Transfer of Closely Held Businesses
If you are an owner of a closely held business, the thought of estate taxes no doubt is an alarming one. If not, it should be.
Federal and state estate and gift taxes, imposed at top marginal rates of 45 percent, together with the generation-skipping transfer tax (GSTT) on transfers to persons two or more generations younger at a flat rate of 45 percent, combined with income taxes imposed over the years, can reduce the value of the business that a family can retain through the generations to an amount as low as 12 percent of the initial value. Thus, without proper planning, the work of a lifetime in growing the assets of your business can be decimated in one or two generations.
While estate tax reform is an item on the national agenda, as of this writing, the nature of estate tax relief is uncertain, so planning to preserve the value of your business
and to transfer assets while minimizing these taxes is prudent. Estate tax policy to tax wealth at each generation (treating spouses as a single unit), avoiding the buildup of
fortunes in families, and to encourage charitable giving, raises doubts as to the likelihood of the elimination of transfer taxes altogether.
What are your goals as the owner of a closely held business? No doubt one goal is to maintain the hard-earned value of your enterprise. Another may be to provide for the orderly
transfer of this value to younger generations, while minimizing transfer (and income) taxes. The form of entity that you select is essential in order to obtain optimal valuations
and tax savings and to ensure good long-term management.
Estate Tax Overview
A review of estate planning rules provides the basis for understanding the techniques discussed herein. Gift taxes, imposed on transfers during life, and estate taxes, imposed on the value of assets owned at death, apply at "unified" marginal rates, starting at 39 percent for cumulative lifetime and estate transfers in excess of the amount exempt from tax by reason of the "unified credit" (currently $1 million) and rising to a marginal rate of 45 percent for transfers in excess of $3 million. Each person should use this credit (and not waste it by giving all of his assets to his spouse) by, for example, transferring the "credit shelter amount" to a trust for the benefit of his spouse and descendants during his life or at death.
Despite the unified rates, the gift tax is more efficient, since it is "tax exclusive," imposed only on the net amount transferred (assuming the transferor lives for at least three
years after making the gift), whereas the estate tax is imposed on all assets owned at death, including the tax dollars.
Consider John Doe, who owns a business worth $10 million. Jim is good at running his business but afraid to transfer too much
control to his son (who comanages the business) during life. At Jim's death, the estate tax on his $10 million business (which he bequeaths to James Jr.) is $5.3 million, leaving
$ 4.7 million for John Jr. The tax of $5.3 million has an effective rate of 115 percent of the net value which James Jr. receives.
If John Doe had been very smart, he would have used proper estate planning techniques to retain a satisfactory degree of control but give the same net amount of $4.7 million to
James Jr. during life for a gift tax of $2.3 million, an effective rate of only 45 percent.
Also, the post-gift appreciation on the assets transferred during life will escape transfer taxes in John's generation altogether. Put another way, the early use of the unified
credit is more valuable than its use many years later at death, because of the time value of money.
Lifetime transfers also can optimize management arrangements, permit leveraging and take advantage of potential discounts for transfer-tax purposes. However, property received
by gift will have a "carryover" basis, as opposed to property received from a decedent which will have a basis "stepped up" to fair market value as of death. Nevertheless, at current
rates, minimizing transfer tax at its marginal rate of 45 percent outweighs the potential cost of capital gains taxes. Proper planning should take also advantage of the right to
transfer $1.03 million (slated to increase annually for inflation) to persons who would otherwise be "skip persons" without attracting the GSTT.
To minimize transfer taxes, do not overlook your right to transfer $13,000 each year to any donee: a married father with four married children and six grandchildren can make "annual
exclusion" gifts in a total amount of $260,000 each year.
Consistent with the policy to tax each generation, qualifying transfers between husband and wife are exempt, deferring the tax until the death of the survivor. The transfer must
be outright or in a "qualified terminable interest property" (QTIP) trust, requiring current distribution of income to the spouse and permitting principal distributions at the
discretion of the trustee, ensuring that assets remaining upon the surviving spouse's death will pass to the transferor's beneficiaries and not to outsiders. (If the surviving
spouse is not a U.S. citizen, special rules apply, requiring a "qualified domestic trust" to obtain the marital deduction.) Combining transfers to family members with transfers
for charitable organizations can provide tax relief and leveraging opportunities.
Choice of Entity
Your choice of entity will affect valuation of interests gifted to members of a younger generation, for example, by supporting discounts. To insulate against the IRS seeking to
reduce a discount by looking through the corporate form to the underlying assets, the entity should limit the power of the owners to force dissolution or liquidation.
A Subchapter C corporation has the impediment of double tax on dividend distributions and liquidations. Also, some state statues offer protection for minority shareholders which
could limit discounting opportunities. However, recent court decisions have supported a discount for built-in capital gains tax when valuing C corporation assets.
Subchapter S corporations avoid the double tax on dividend distributions and liquidations, but may be subject to a potential tax on liquidation, a built-in gains tax if previously
a C corporation, and minority shareholder protection statutes. Only certain forms of trusts are permitted S shareholders: the "qualified subchapter S trust" (QSST) and the "electing
small business trust" (ESBT). Since opportunities for traditional "estate freeze" techniques, such as the preferred stock recapitalization, have been severely restricted pursuant
to Chapter 14, an S corporation may be attractive as it may have voting and nonvoting stock without violating its one class of stock requirement.
Nonvoting stock may be transferred to a QSST or ESBT for younger beneficiaries, taking advantage of valuation discounts, shifting current income, and removing value and appreciation
from the estate, without jeopardizing control. Corporate formalities must be observed and valuation and management techniques must compare to an arms-length transaction. See, Speca
v. Com'r, T.C. Memo 1979-120, aff'd. 630 F.2d 554 (7th Cir. 1980). Cf. Kirkpatrick v. Com'r, T.C. Memo 1977-282.
A general partnership avoids the double tax imposed on C corporations, but democracy of management and the power of the general partner to force liquidation or dissolution can
limit valuation discounts. Also, the transfer of a general partnership interest may be costly for transfer tax purposes. Limited partnerships and limited liability companies (permitted
by most state statutes) are important planning tools.
Taxable like a partnership (easily elected under the "check-the-box" rules), an LLC also enjoys limited liability. The Operating Agreement can:
1. provide guidelines for ownership,
management and transfer of LLC interests, for example,
granting a right of first refusal to, or requiring a
vote by, the members of the LLC on transfer of an interest
or sale of LLC assets;
2. restrict transfers to descendants of the
original owner (or to a trust for a spouse of a descendant),
maintaining family control; and
3. restrict withdrawals and limit the sales
price of an interest in the LLC.
Some state LLC statutes contain similar restrictions
and can prevent dissolution in the event of death or
gift. These restrictions support valuation discounts.
An election may be made to adjust both the "outside" and "inside" basis of
the LLC assets held at death to reflect fair market value. Notably, the owner
of a closely held business can transfer interests in the LLC to younger beneficiaries
(for transfer tax purposes), but maintain control by requiring a unanimous
vote by the original business owner(s) for certain transactions. This is an
exception from the general estate planning rule that in order to remove assets
from the owner's estate for tax purposes, control cannot be maintained over
the assets transferred.
Valuation rules are key in tax planning. The "fair market value" of
a business interest is the price at which the interest
would change hands between a willing
buyer and a willing seller, neither party being under compulsion and both having
reasonable knowledge of relevant facts. Treas. Reg. @ 20.2031-1(b). Rev. Rul.
59-60, 1959 CB 237. Relevant criteria include the nature, history and outlook
of the business and its industry; the book value of the shares; the company's
earning and dividend paying capacity; the existence of goodwill; prior sales
of the company's shares; the size of the block of shares to be valued; and the
market price of shares of publicly traded companies engaged in a similar business.
In the case of a closely held business, a valuation discount may be obtained
a. a minority interest discount, reflecting lack of control
over decisions such as the election of directors or officers, salary levels,
the timing and amount of distributions and whether to compel liquidation;
A range of percentages may be achieved for discounts. Specially qualified appraisers
of discounts sometimes compute the discount by combining (or multiplying) the
relevant factors. In Lauder v. Com'r, 68 T.C.M. 985 (1994), the Tax Court allowed
a 40 percent discount for lack of marketability; it allowed a 35 percent discount
for lack of marketability in Jung v. Com'r, 101 T.C. 412 (1993), and permitted
a 36 percent discount in Gallo v. Com'r, 50 T.C.M. 470 (1985). Recently, the
IRS has indicated that a 25 percent discount will not be challenged when claimed
in an appropriate context. On the other hand, the IRS may counter a claim for
a discount by seeking to tax a premium for control. See, Murphy v. Com'r, 60
T.C.M. 645 (1990).
b. lack of marketability discount, reflecting the lack of a ready
market for closely held shares (including a controlling block, because of
the absence of a private placement market and the potential costs of a public
stock offering). See, Estate of Andrews, 79 T.C. 938 (1982);
c. a fractional interest discount, reflecting ownership of less than
an entire interest and that no single owner has total management control;
d. key person discount, reflecting the possible loss of a key person;
e. built-in capital gains discount - reflecting the tax on inherent
capital gains. See, Estate of Babe v. Com'r, 110 T.C. 530 (1998); Eisenberg
v. Com'r, 155 F. 3b 50(2d Cir. 1998);
f. blockage discount, reflecting the potential loss of value when
trading a large block of stock (a discount which may be available for publicly
traded as well as closely held shares); and
g. investment company discount, reflecting diversification and timing
risks. Although in the past the IRS has argued that a family would act in
concert, it has now agreed that minority interests transferred to family
members should not be aggregated for purposes of evaluating discounts for
lack of control. See, Estate of Bright v. Com'r, 658 F. 2d. 999 (5th Cir.
1981); Rev. Rul. 93-12, 1993-1 CB 202.
However, even a control premium can be turned to the advantage of an owner, who
could bequeath 51 percent of the business to his spouse tax-free and 49 percent
to a trust for the benefit of his children, claiming a majority interest discount.
If the surviving spouse subsequently gifts at least 2 percent of her interest
to the children's trust, her estate can claim a minority interest discount and
avoid a control premium. See, Chenoweth v. Com'r, 88 T.C. 1577 (1987). This is
better than a bequest to the spouse, merely deferring tax until her death. A
series of gifts, each entitled to a fractional interest discount, can be effective,
provided that transfers from a deathbed will be ignored. See, TAM 9723009 and
Buy, Sell Agreements
A buy and sell agreement can provide liquidity to the family of a deceased business
owner and ensure continued control by the surviving managers. Buy and sell agreements
should be carefully established and funded (for example, with life insurance)
while the key persons are alive and well. A buy and sell agreement can avoid
a transfer to an undesired third party (protecting S election or professional
Forms of buy and sell agreements include a redemption or repurchase agreement
- made between the owner and the entity; a cross-purchase agreement - made by
and among the owners; or a hybrid agreement - where the entity is obligated (or
has an option) to purchase the ownership interest of the deceased or withdrawing
partner, but can assign its purchase right to the remaining owners.
Life insurance is valuable in estate planning as, in general, the proceeds and
growth in the invested assets are exempt from income tax. This may be more effective
than investing in an IRA, which can convert capital gain to ordinary income,
taxable upon withdrawal from the plan.
Life insurance also compares favorably to investing outside any plan, subject
to current income tax. New forms of insurance afford greater investment discretion
to policy owners. Also, opportunities exist with insurance for "leveraging" the
transfer of value to a trust, which is the policy owner and beneficiary, for
example, for the benefit of the insured's spouse and descendants. This is especially
true with "split-dollar" life insurance, where the entity advances premiums on
behalf of an employee, transferring value to an insurance trust. In transactions
involving life insurance, care must be taken to avoid the "transfer for value" rule,
subjecting insurance proceeds to income taxation if the policy is transferred
for valuable consideration.
With a "private annuity" a business owner may transfer ownership to his family
members in exchange for their unsecured promise to make payments to him for life.
Properly structured, no gift tax will be payable (if the present value of the
payments stream equals the value of the transferred property); capital gains
tax will be minimized; and the value of the annuity will be excluded from the
The annual payments cannot be funded directly from the transferred property or
the property may be included in the transferor's estate. Each annuity payment
will be partially a return of capital (recovery of basis), partially capital
gain and partially ordinary income (the interest portion of the annuity payment).
The basis of the transferee in the transferred property will equal the present
value of the annuity, with each payment increasing his basis in the property.
See, Rev. Rul. 55-119, 1955-1 CB 353.
Defective Grantor Trusts
With a "defective grantor trust," an owner can transfer his business interest
to a trust (for the benefit of his spouse and descendants) with provisions causing
him to be taxable on the trust's income (as opposed to the general rule subjecting
the trust to tax on its income).
This payment of tax by the grantor represents a gift tax-free transfer to his
beneficiaries. Combining this with valuation discounts can make this straightforward
The use of trusts can be combined with entity selection for ownership and transfer
tax purposes. For example, interests in an LLC can be transferred to a trust
for the benefit of the owner's descendants, providing a valuable shield from
claims of the beneficiary's (1) unforeseen creditors, (2) a spouse at death (insulating
against spouse's "right of election") and (3) a spouse in divorce. With a "grantor
retained annuity trust" (GRAT), a family business owner can transfer the economic
value of a business and future appreciation in the business for reduced transfer
taxes, while retaining the right to a stream of payments from the business and
a measure of control over management (gift tax being imposed only on the value
of the remainder interest, after taking into account the value of the annuity).
An LLC owner can transfer his interest to a defective grantor trust for an installment
note, bearing minimum required interest, discounted to reflect applicable restrictions.
Since transactions between a grantor trust and its owner are ignored for income
tax purposes, the transferor may avoid capital gains tax on the sale of his LLC
interest to the trust. (The death of the transferor during the term of the note
may attract capital gains tax.) This can transfer future appreciation for low
transfer tax, remove the asset from the transferor's estate, minimize capital
gains tax and benefit from the low interest rates prescribed for loans (as compared
to the rate which applies for a GRAT). Also, better GSTT opportunities exist
for an installment sale than for a GRAT.
The qualified family-owned business estate tax deduction (QFOBI) is computed
in conjunction with the unified credit for a maximum aggregate amount of $675,000.
To qualify, the "qualified family-owned business interest" must comprise at least
50 percent of the adjusted gross estate, the business interest must either be
a sole proprietorship or an interest in an entity in which the decedent and his
family hold a certain percentage interest, and the decedent or members of his
family must have "materially participated" in the operation of the business for
a period aggregating five years or more during the eight-year period before the
decedent's death and certain conditions must exist after death to avoid recapture.
A transfer of a business interest can be combined with a deduction for a transfer
to a charitable organization. For example, an owner could donate closely held
stock to a charity for a charitable deduction, after which the charity could
redeem the stock. Tax on capital gains would be avoided by the exempt charity
and the redemption by the charity may constitute an indirect transfer of assets
to the younger generation (if they hold an interest in the business prior to
the charitable transfer), provided no prearranged obligation to redeem the shares
Alternatively, corporate stock could be contributed to a charitable remainder
trust, which could then redeem the stock. The proceeds of redemption could be
reinvested in higher yielding, more diversified assets, while reducing income
tax on the redemption, providing the transferor with annual distributions from
the trust and an income tax deduction for the actuarial value of the charity's
remainder interest. At the death of the transferor, the portion of the trust
property includable in his estate will be offset by a corresponding estate tax
deduction for the charity's interest.
An ESOP is a qualified employee benefit plan designed to invest primarily in
stock of the sponsoring employer.
An ESOP can create a market for privately held shares and provide shareholders
with access to the value of their shares on a tax-deferred basis without the
loss of control. ESOPs can be effective in providing liquidity to pay estate
taxes; deferral or avoidance of tax on income as it is recognized; the conversion
of ordinary income to capital gain; and the facilitation of private business
ESOPs can provide an attractive alternative to the sale of the business if younger
executives have been adequately trained as managers. Control can be retained
by the family by selling a minority interest to the ESOP, or if the ESOP holds
a majority interest by selecting the trustee with the right to vote the stock
or by subjecting the trustee to direction from a committee selected by the Board
The ESOP has certain potential disadvantages. Participants will share in the
future growth of the business on a pro-rata basis. However, the "cost" of sharing
equity with employees may be offset by increases in employee productivity, reductions
in other employee benefits and tax savings to the corporation. Note that if the
stock of an employer that sponsors an ESOP is not publicly traded, the participants
have the right to require the sponsoring employer (not the ESOP) to repurchase
any shares distributed to them. Before establishing an ESOP, the company should
consider whether this put option might impose an undue financial burden on the
If a taxpayer elects to defer recognition of gain in connection with the sale
of stock to an ESOP, the taxpayer will take a carryover basis in the qualified
replacement property. Opportunities exist for investing the ESOP sales proceeds
since the longer the replacement properties are held, the longer the tax on the
gain realized on the ESOP transaction can be deferred. Capital gains tax can
be avoided altogether if the replacement properties are held until the death
of the taxpayer, due to the step-up in basis of assets held at death. Also, company
stock can be gifted to a limited partnership or a charitable trust which can
then sell stock to an ESOP.
A Business Alternative
An alternative that minimizes transfer taxes is the establishment of a "competing" company,
owned and controlled by the younger generation, that gradually receives almost
the entire business of the original corporation, as the management of the corporation
retires and the allegiance of the customers is transferred.
Numerous estate planning techniques exist, ranging from simple to complex, to
reduce transfer tax on a closely held company. Proper planning is essential to
avoid the potentially confiscatory effects of these taxes on the value of your
(1) All references herein to Chapters, Subchapters or sections are to the Internal
Revenue Code of 1986, as amended, unless otherwise stated.
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Charles M. Bloom, Registered Principal offers securities
and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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